ECB Paper Defends HFT, Says It Supports Efficient Price Discovery

The European Central Bank (ECB) has released a working paper defending high frequency trading (HFT), saying that it helps with more efficient price discovery because HFT on average trades against transitory pricing errors.

ECB defending HFT

“Our analysis suggests that HFTs impose adverse selection costs on other investors. At the same time, HFTs being informed allows them to play a beneficial role in price efficiency by trading in the opposite direction to transitory pricing errors and in the same direction as future efficient price movements,” write Jonathon Brogaard, Terrence Hendershott, and Ryan Riordan for the ECB.

When institutional investors make large trades, they often spread them out over a number over smaller trades to try to cover their tracks. This series of trades moves the stock price, creating what the ECB paper calls a transitory pricing error. If HFTs trade in the same direction as the pricing error they will increase transaction costs for large investors (or increase risk by forcing them to spread trades out even more), but if they trade in the opposite direction they should reduce transaction costs. The authors’ main conclusion is that, since HFTs trade against transitory effects they shouldn’t be discouraged.

HFT role in market

But, as the authors say, HFTs create an “adverse selection cost” for everyone else on the market, and it’s this deeper issue of fairness that has most people upset. The ECB working paper acknowledges that this is a concern, but doesn’t seem to think it’s very important. “The substantial, largely negative media coverage of HFTs and the “flash crash” on May 6, 2010 raise significant interest and concerns about the fairness of markets and HFTs’ role in the stability and price efficiency of markets,” they write, before devoting a a lot of energy to defending HFT’s role in market stability while essentially ignoring the issue of fairness.

The only significant comment is to point out that “like traditional intermediaries HFTs have short holding periods and trade frequently. Unlike traditional intermediaries, however, HFTs are not granted privileged access to the market unavailable to others. Without such privileges, there is no clear basis for imposing the traditional obligations of market makers.”

Strictly speaking, this is true. But HFT requires expensive infrastructure and a technically sophisticated team that creates a steep barrier to entry. Price efficiency is important, but the issue of fairness shouldn’t be dismissed quite so readily.